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Monetary Policy and the Taylor Principle in Open Economies

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  • Ludger Linnemann
  • Andreas Schabert

Abstract

Nowadays, central banks mostly conduct monetary policy by setting nominal interest rates. A widely held view is that central banks can stabilize inflation if they follow the Taylor principle, which requires raising the nominal interest rate more than one-for-one in response to higher inflation. Is this also correct in an economy open to international trade? Exchange rate changes triggered by interest rate policy might interfere with inflation stabilization if they alter import prices. The paper shows that this destabilizing effect can prevail if (a) the central bank uses consumer (rather than producer) prices as its inflation indicator or directly reacts to currency depreciation, and (b) if it bases interest rate decisions on expected future inflation. Thus, if the central bank looks at current inflation rates and ignores exchange rate changes, Taylor-style interest rate setting policies are advisable in open economies as well. Copyright 2006 Blackwell Publishing Ltd.

Suggested Citation

  • Ludger Linnemann & Andreas Schabert, 2006. "Monetary Policy and the Taylor Principle in Open Economies," International Finance, Wiley Blackwell, vol. 9(3), pages 343-367, December.
  • Handle: RePEc:bla:intfin:v:9:y:2006:i:3:p:343-367
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    Cited by:

    1. Araújo, Eurilton, 2016. "Determinacy and learnability of equilibrium in a small-open economy with sticky wages and prices," International Review of Economics & Finance, Elsevier, vol. 45(C), pages 16-32.
    2. Stephen McKnight, 2011. "Investment and interest rate policy in the open economy," Oxford Economic Papers, Oxford University Press, vol. 63(4), pages 673-699, December.
    3. Stephen McKnight & Alexander Mihailov, 2015. "Do Real Balance Effects Invalidate the Taylor Principle in Closed and Open Economies?," Economica, London School of Economics and Political Science, vol. 82(328), pages 938-975, October.
    4. Leith, Campbell & Wren-Lewis, Simon, 2009. "Taylor rules in the open economy," European Economic Review, Elsevier, vol. 53(8), pages 971-995, November.
    5. Borek Vasicek, 2010. "Monetary Policy Rules and Inflation Processes in Open Emerging Economies," Eastern European Economics, Taylor & Francis Journals, vol. 48(4), pages 36-58, January.
    6. Martin Feldkircher & Florian Huber & Isabella Moder, 2016. "Modeling the evolution of monetary policy rules in CESEE," Focus on European Economic Integration, Oesterreichische Nationalbank (Austrian Central Bank), issue 1, pages 8-27.

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